06. August 2021

Dollarisation Does Not Go Hand In Hand With Heightened Financial Market Risks, Study Says Press release: Dollarisation Does Not Go Hand In Hand With Heightened Financial Market Risks, Study Says

Financial Dollarisation in emerging market economies does not necessarily lead to more vulnerability in the respective financial system, according to a recently published study with the participation of the University of Mannheim. “The common view that financial dollarisation is a source of fragility is overstated,” the authors said.

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Dollarisation means the use of a foreign currency in parallel to or instead of the domestic currency
and is widespread in a number of developing and emerging market economies. Deposit dollarisation
can be seen as an insurance arrangement, mainly between different people inside individual countries
rather than between agents across countries.

The median cross-country flows due to dollar debt are on average around half of the within-country
flows, according to the authors, who used different datasets over the period 2000 to 2018 from up to
16 countries.

Insurance of dollar deposits comes from the fact that the US Dollar tends to gain in value when the
local economy is in recession. “For many people - mostly the US audience - deposits sound like a trivial
instrument but for most countries, specifically emerging market economies, deposits are the main
saving device for residents,” the authors explained.

Households who denominate their deposits in dollars are purchasing a business cycle insurance, according
to the study.

The ‘price’ paid by the depositors for this insurance is the premium on the local interest rate. The
payoff from the insurance is the spike in the dollar return that occurs when the local currency depreciates
in a recession.

The results of the discussion paper “sketched a relatively benign picture of deposit dollarisation,”
Lawrence Christiano from the Northwestern University, Husnu Dalgic from the University of Mannheim
and Armen Nurbekyan from the Central Bank of Armenia wrote. “However, there is a persistent
view that deposit dollarisation is dangerous, by increasing the vulnerability of banks to a systemic

Still, the study’s data suggest that dollarisation “does not raise the risk of financial crises because the
currency mismatch it creates is in the hands of low-leveraged firms that can handle exchange rate
fluctuations,” the authors said. Currency mismatch describes a situation when a household’s loan is
denominated in a foreign currency, so that the cost of serving it varies with the exchange rate.

At the same time, the results show that the bulk of insurance supply to households is borne by nonfinancial
firms, not by banks, not at least because of more prudential banking regulations, therefore
limiting potential direct negative repercussions to the banking sector.

The view that dollarisation might lead to lower investment and employment due to a recessioncaused
depreciation of the currency was also not substantiated by the study’s results. „Sales and GDP
apper to be the main drivers of non-financial firm investment, not exchange rate fluctuations per
se,“ Christiano, Dalgic and Nurbekyan stated.

Moreover, the researchers didn’t find empirical evidence for the view that financial dollarisation creates
significant over-reaction to exchange rate movements. Instead, data „suggest that the contribution
of financial dollarisation to volatility is minimal,“ they wrote.

„Deposit dollarisation has no predictive power for financial crises or for the severity of a crisis when it
happens, according to the authors. „While our results are consistent with existing findings that too
much borrowing raises the risk of crisis, the currency denomination of debt does not, per se, increase
that probability.“

Husnu Dalgic, Ph.D. is member of the Collaborative Research Center Transregio 224 EPoS. The presented discussion paper is a publication without peer review of the Collaborative Research Center Transregio 224 EPoS.

Discussion Paper No. 306
Project C 02

Financial Dollarization in Emerging Markets:
Efficient Risk Sharing or Prescription for Disaster?
Lawrence Christiano
Husnu Dalgic
Armen Nurbekyan

For further information and interview requests, please contact the author of the study:

Husnu Dalgic, Ph.D.
Department of Economics
Mannheim University
Phone: +49 621-181-1958
Email: hdalgic@mail.uni-mannheim.de



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